Elephant in the Oil Industry

Theres an elephant in the oil industry, and the longer Wall Street ignores it, the easier its going to be for savvy investors to make money.

Youve seen the record profits big oil companies have racked up in the last quarter ExxonMobils $10 billion, Shells $9 billion profit, and more.

But thats not where the biggest profit potential lies. It lies in the fact that …

Big oil companies like these cant seem to find any more oil, and to get it, theyre going to have to buy up smaller companies that arent on Wall Streets radar screen.

Even as Exxon reported those humongous profits, its oil-equivalent production totals actually fell 4.7%.

Ah, but that has to be due to the hurricanes that ripped through the Gulf of Mexico, right? Yes, but not entirely. Even excluding the impact of the hurricanes, production still declined 1%.

According to the Financial Times, Exxon said higher liquids production from new fields in West Africa and higher gas volumes from projects in Qatar and the UK were offset by the impact of mature field declines.

Meanwhile, last year, more than 90% of Exxons new reserves came from just one field in Qatar. And guess what! It wasnt even oil. It was a natural gas deposit. How much new petroleum did Exxon find last year overall? None. Nada.

Shell is in even worse straits. Its production volume fell by 11% in the past year partially, but not entirely, due to Katrina and Rita.

Are all big oil companies suffering production declines? No. But for every company like BP or Petrobras with expanding production, there seem to be at least as many with contracting production: Chevron, Royal Dutch Shell, Conoco Phillips. The list goes on and on.

Obviously, those big companies like making the big profits, and theyre going to have to find that oil somewhere. So you can bet dollars to doughnuts that theyre either going to buy it from smaller companies or buy the companies themselves.

Meanwhile …

In Prudhoe Bay, the Production
Drop-Off is Getting Freakin’ Scary

Did you see the Associated Press story that just came out this weekend about Prudhoe Bay? Take a look …

Alaskan North Slope oil production, once heralded as a domestic mother lode, has hit a new output low embodying the precarious balance confronting the U.S. as it struggles for energy security in an era of volatility in the international oil market.

The decline in Alaska is led by a slump in output from the once-mammoth Prudhoe Bay field, which has been producing since 1969. At its height in fiscal 1988, the field produced an average of 1.6 million barrels per day; but in fiscal 2005, it was down to 381,000 barrels per day. Overall production in the North Slope has dropped to an average of 916,000 barrels per day from 2.01 million barrels in the same period.

In Alaska, re-boosting output is as much dictated by politics as it is by geology.

While President Bush’s administration has pushed for opening a pristine refuge believed to hold about 10 billion barrels of recoverable crude oil, environmentalists argue such a move would only temporarily delay the inevitable while ruining the delicate Arctic habitat.

Projections for new fields slated to come on-stream over the next 10 years are expected to do little but temporarily offset the decline. North Slope output, according to the state, is projected to drop to about 833,000 barrels per day by 2015, with 50 percent of that production coming from new fields.

My view on Prudhoe Bay: Long term, this is a warning to us all about fossil fuels. Either we start working on viable energy alternatives soon, or well find ourselves up the creek and without a paddle.

And right here and now, it completely validates the whole argument Im making here: Oil production is declining precisely when its most needed.

And if these werent bad enough …

OPEC Hints it May Cut
Oil Production in 2006

And no wonder! Consider the facts:

Saudi Arabia, the central bank of oil, is seeing production from its existing oil fields decline by 5% to 12% every year. They say they can make up for it with new drilling. But dont hold your breath.

Kuwaits big oil field the second largest in the world has peaked. Farouk al-Zanki, the chairman of state-owned Kuwait Oil Company, says production is topping out at 1.7 million barrels per day, rather than at the 2 million they had hoped for. Its all downhill from here.

Iran cant even meet its current OPEC production quota, and is losing production at a rate of 300,000 bpd each year.

So there you have it: Production falling. Demand rising. Obvious, right? So why didnt the energy experts see it coming? Heres one very strange reason:

The Mysterious
Missing Decimal

For years, the Energy Information Agency (EIA) insisted that oil prices would decline over the next quarter century until it bottomed out at around $31 per barrel by the year 2030.

It forever boggled my mind how they could possibly arrive at that conclusion. Well, they got their math wrong.

Seriously! The EIA actually misplaced a decimal in its calculations.

Oops! Now, it says that oil will remain around $50 a barrel for years to come and should be around the $57 price level in 2030.

Its nice to see the good folks at the EIA admit they made a mistake, but I think their price targets are still way too conservative. Im wondering if theres another math error they havent discovered yet.

Oil Recently Hit a High of $70,
And I Think Its Going Back
There Sooner Rather Than Later.

Oil is still in a solid uptrend.

Despite all the up-and-down movement in recent months, despite all the back-and-forth debate, that has NEVER changed.

Now, oil has suffered its correction. Plus, it has turned back up, resuming its uptrend.

Sure, you may see some more ups and downs, driven by random things like weather and market psychology. But theres nothing random about the massive collision between declining production and rising demand.

Look. Back in 1982, the US had the ability to refine 18.62 million barrels of oil per day. Today we can refine roughly 16.76 million.

Meanwhile, despite the need for more supplies, the costs of starting a new facility are far greater today. Thats why, in 1981, we had 324 refineries. Today we have only 146.

Meanwhile, demand for oil and gas is continuing to rise. Demand in China and India are red hot. Demand in the U.S. surged 1.1 million barrels a day to 21.6 million in the week ended December 9, the highest level ever. Overall, higher prices this year have done virtually nothing to dampen the worldwide demand surge.

To me, all of this is a signal that big oil is going to start a bidding war for scarce production facilities and even scarcer reserves. In fact …

Earlier, Chevron acquired Unocal for some $17 billion … China National Petroleum Corp bought Canadian oil company PetroKazakhstan for $4.2 billion … and Occidental Petroleum announced it was going to buy Vintage Petroleum for $3.52 billion.

In all, U.S. energy companies spent more than $197 billion on acquisitions this year DOUBLE what they spent in 2004.

This is just beginning to gain momentum. Get ready for much more in 2006.

How to Play It

First, theres no such thing as a sure bet in any market. The only way you can guarantee a return is with money markets. And short-term Treasury bills or equivalent money funds are the safest.

Second, even though their production is declining, the fat profits of the oil majors are bound to get still fatter. So I dont think you can go wrong with the Energy Select SPDR (XLE).

Third, I think you can do better with the Oil Service HOLDRS (OIH), a basket of oil service stocks, including companies that do the drilling. It gives you a play on the demand for expanded production, and I think it should outperform the XLE going forward.

Fourth, as an alternative, you could go for a good energy sector fund. Im partial to the Fidelity Select Energy Service (FSESX) because its the largest, pure-play, no-load, oil services mutual fund. It returned 49.21% in 2005 through November 30. And I think its going to have a great 2006 as well.

Fifth, I have recommended two small cap energy stocks in my recently-launched Red-Hot Canadian Small-Caps. Both of them are already moving up, with one up about 26% in less than three weeks.

But its the other one that I think is the real sleeping beauty about to be awakened. It increased its oil and gas reserves by more than 55% in the most recent quarter. I think its got to be in the sights of the bigger energy companies.

Next, Im looking to add more undervalued companies. I have five on my radar screen right now. Give me a few days, though. Im still crunching the numbers to determine which one is best of breed in each category.

Best wishes,

Sean

About MONEY AND MARKETS

MONEY AND MARKETS (MAM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Larry Edelson, Tony Sagami and other contributors. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MAM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MAM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Contributors include Marie Albin, John Burke, Beth Cain, Christine Johnston, Amber Dakar, Michael Larson, Monica Lewman-Garcia, Julie Trudeau and others.